This site uses cookies to store information on your computer. Some are essential to make our site work; others help us improve the user experience. By using the site, you consent to the placement of these cookies. Read our privacy policy to learn more.

As if a recession, the credit crisis and the housing downturn were
not causing enough stress, many companies, and their accountants and
auditors, must also consider an accounting issue that has become
increasingly pressing—should their investments be considered
“other-than-temporarily impaired”? This issue is relevant not only for
financial institutions but for any company that holds corporate debt,
structured investment securities (CDOs, mortgage-backed and other
asset-backed securities) or equities.

Some market analysts and members of the financial press have blamed
U.S. GAAP’s fair value accounting requirements for exacerbating
financial markets’ instability. Frequently, critics attribute the
problem to the application of FASB Statement no. 157, Fair Value
Measurements. However, Statement no.157 provides guidance on
how to measure fair value, not when assets should be
recorded at fair value.

The real controversy comes from accounting standards that require
entities to measure certain assets or liabilities at fair value.
During market downturns, the accounting requirements relating to
recognition of impairment on investment securities become especially
contentious. These rules require accountants to make subjective
assessments in determining when impairment should be considered “other
than temporary,” and if so, to write down the impaired asset to its
fair value with a charge to current-period earnings. Companies are
generally reluctant to take such impairment charges because once a new
cost basis is established from the write-down, any subsequent
appreciation in fair value of the impaired security may not be
recognized until the security is sold. At the same time, the decision
not to recognize impairment is subject to close scrutiny by analysts
and regulators.

This article discusses current accounting requirements relating to
the assessment of impairment of equity securities with readily
determinable fair values and all debt securities, including the
effects of the recently issued FASB Staff Position no. EITF 99-20-1,
Amendments to the Impairment Guidance of EITF Issue No.
99-20. It also summarizes the disclosure requirements for
securities that have fair values below recorded cost. While there are
no “bright lines” for making the impairment determination, this
article summarizes the authoritative accounting guidance and
reiterates some of the previously stated SEC staff views on the
matter. In addition, this article provides some practical
considerations that may help entities avoid unwanted scrutiny about
their impairment decisions.

MORE CHANGE IN THE WINDFASB recently added a project to its agenda, titled “Recoveries
of Other-Than-Temporary Impairments (Reversals),” which could
significantly affect accounting for impairment on securities. In a
related project, the FASB recently issued FSP FAS 107-a,
Disclosures about Certain Financial Assets, to increase the
comparability of certain financial instruments that have similar
economic characteristics but different measurement attributes. All of
these efforts reflect FASB’s effort to improve the accounting and
reporting for financial instruments while moving toward convergence
with IFRS.

CATEGORIES OF INVESTMENT SECURITIESFASB Statement no. 115, Accounting for Certain Investments in
Debt and Equity Securities, is the authoritative accounting
guidance for investments in debt and equity securities with readily
determinable fair values. Statement no. 115 requires entities to
classify investment securities into one of three categories upon acquisition:

Held-to-maturity (HTM)

Trading

Available-for-sale (AFS)

In addition to defining the three classifications of securities,
Statement no. 115 requires entities to assess their AFS and HTM
securities each reporting period to determine whether declines in fair
value below book value are to be considered other than temporary.
Trading securities are marked to fair value each reporting period and
are not subject to ongoing impairment analyses since their unrealized
losses (if any) have already been included in earnings.

If impairment is considered other than temporary, the holder must
write down the cost basis of the impaired security to fair value. The
amount of the write-down is included in earnings as a realized loss,
and a new cost basis is established for the security. Any subsequent
recovery in fair value is not recognized in earnings until the
security is sold.

PROCESS FOR ASSESSING IMPAIRMENTTwo accounting models are used to assess impairment on
securities, and until recently, they were very distinct. One model is
defined in Emerging Issues Task Force Issue no. 99-20, Recognition
of Interest Income and Impairment on Purchased Beneficial Interests
and Beneficial Interests That Continue to Be Held by a Transferor in
Securitized Financial Assets, and applies to credit-sensitive
mortgage and other asset-backed securities and certain
prepayment-sensitive securities. For all other securities, except
investments accounted for under the “equity” method, entities follow
the approach in paragraph 16 of Statement no. 115 that is further
explained in FSP FAS 115-1 and FAS 124-1, The Meaning of
Other-Than-Temporary Impairment and Its Application to Certain Investments.

THE FASB 115 MODELFAS 115 and its amendments provide a three-step process for
determining whether impairment should be considered other than temporary.

1. Determine whether the investment is impaired. An
investment is impaired if its fair value is less than its amortized
cost basis (book value). The cost basis of an investment includes
adjustments made for accretion, amortization, other impairments and
hedging. Entities should make this assessment at the individual
security level each reporting period. (FSP FAS 115-1 also discusses
how to assess impairment on “cost method investments.” The steps for
assessing impairment are essentially the same as for marketable equity
securities and debt instruments, but because the fair value of cost
method investments may not be readily available, FSP FAS 115-1
describes a different approach for obtaining fair value and the
related disclosures.)

2. Evaluate whether the impairment is other than temporary.
Entities must evaluate impairment based on specific factors
including the nature and extent of the decrease in fair value of the
security below cost. This is a subjective assessment that is discussed
in more detail below.

3. If the impairment is other than temporary, recognize an
impairment loss equal to the difference between the investment’s
cost and its fair value.The amount of the write-down is
the difference between amortized cost and the fair value of the
investment on the balance sheet date. When impairment is recognized,
the fair value of the impaired security becomes the new cost basis of
the investment, and subsequent recoveries in fair value are not
recognized in earnings until the security is sold or matures.

THE REVISED EITF 99-20 MODELThe previous EITF 99-20 model was more stringent than the
Statement no. 115 model because it was triggered by any adverse change
in the estimated timing or amount of cash flows that “market
participants” would use as opposed to the more subjective assessment
of whether impairment is other than temporary. The application of this
model resulted in outcomes that some practitioners considered
inappropriate because it did not permit management to consider the
probability that all previously projected cash flows would be
collected. For example, recently, there has not been an active market
for CDOs and certain other structured mortgage securities. While most
cash flow models indicate there have been adverse changes in the
projected cash flows of these securities, the present value of those
cash flows may be significantly higher than the observed fair value of
the security in an illiquid market. In these situations, some
practitioners believe that application of the EITF 99-20 model
resulted in recognition of an impairment loss that would not have been
required for similar securities under the FAS 115 approach.

On Jan. 12, 2009, FASB issued FSP EITF 99-20-1 to more closely align
the EITF 99-20 impairment model with that of Statement 115 and its
implementation guidance. By eliminating the key distinctions between
the two models, the amendment results in more consistent criteria for
determining whether an other-than-temporary impairment has occurred
for all securities. Specifically, FSP EITF 99-20-1 replaces the
requirement to use market participant assumptions when determining
future cash flows and instead, requires an assessment of whether it is
probable that there has been an adverse change in estimated
cash flows (see Exhibit 1).

DISCLOSURE REQUIREMENTSAn important aspect of an entity’s accounting for securities is
the disclosures it makes about securities that are “underwater”
(securities whose fair value is less than book value). Specifically,
FSP FAS 115-1 requires entities to disclose the amounts of unrealized
losses and the aggregated fair value of investments with unrealized
losses. These disclosures should be segregated into two buckets—those
investments that have been in a continuous unrealized loss position
for less than 12 months and those that have been in a continuous
unrealized loss position for 12 months or longer. The reference point
for determining how long an investment has been in a continuous
unrealized loss position is the balance sheet date of the reporting
period in which the impairment is initially identified. Exhibit
2 provides an example of the required disclosure.

Entities must disclose additional information (in narrative form) in
the notes to the financial statement to provide insight into the
company’s rationale for reaching the conclusion that existing
impairment(s) is temporary. Such additional information may include:

(1) The nature of the investment(s).

(2) The cause(s) of the impairment(s).

(3) The number of investment positions that are in an unrealized
loss position.

(4) The severity and duration of the impairment(s).

(5) Other evidence considered in reaching its conclusion that the
investment is not other-than-temporarily impaired.

In addition, the SEC staff noted in its Nov. 30, 2006, Current
Accounting and Disclosure Issues in the Division of Corporation
Finance (Nov. 30, 2006 SEC Guidance), that a recognized or
potential other-than-temporary impairment may require discussion in
the management’s discussion and analysis (MD&A) section of SEC
filings if the amount of loss or potential loss is material, or in
certain other circumstances, where discussion would be necessary to
provide the reader with an understanding of financial condition or
results of operations.

Arguably, the focus of these disclosure requirements suggest a
presumption that securities that are underwater for an extended period
of time should generally be considered other-than-temporarily impaired
unless there is a reasonable justification for concluding that the
recorded value will ultimately be realized. The disclosure
requirements suggest an important threshold is 12 months, but in
practice many companies have securities that have been underwater for
18 to 24 months and do not consider them to be other-than-temporarily impaired.

EVALUATING “OTHER-THAN-TEMPORARY” IMPAIRMENTIn its discussion about impairment, paragraph 16 of Statement
no. 115 indicates: “For example, if it is probable that the investor
will be unable to collect all amounts due according to the contractual
terms of a debt security not impaired at acquisition, an
other-than-temporary impairment should be considered to have
occurred.” In making the assessment, the holder must consider all
available evidence, including the issuer’s financial condition and
near-term prospects, the severity and duration of the decline in fair
value, and the investor’s intent and ability to hold the investment
for a reasonable period of time sufficient for a forecasted recovery.

The SEC staff indicated in its Nov. 30, 2006, guidance and previous
guidance that it is inappropriate to apply “bright line” or “rule of
thumb” tests in making the assessment, so accountants must use
judgment. Because the decision about whether the decline in fair value
of a security is other-than-temporary is subjective, it often is
included as a critical accounting assumption in the notes to the
financial statements, particularly for companies with significant
investment portfolios.

Even though FSP FAS 115-1 is the definitive accounting guidance on
the meaning of other-than-temporary impairment, it refers to other
accounting literature for guidance in evaluating impairment.
Similarly, both Statement no. 115, and the FASB staff implementation
guidance relating to Statement no. 115 refer to SEC Staff Accounting
Bulletin (SAB) no. 59, codified as SAB Topic 5.M, Other Than
Temporary Impairment of Certain Investments in Debt and Equity
Securities (SAB 59), and Statement on Auditing Standards no. 92,
Auditing Derivative Instruments, Hedging Activities, and
Investments in Securities (SAS no. 92), for guidance.

In addition to the factors mentioned above, SAB 59 and SAS no. 92
identify several factors that indicate other-than-temporary impairment
of a security’s value has occurred. These factors should be evaluated
both individually and collectively and include:

The length of time and extent to which the market value
has been less than cost.

The financial condition and near-term prospects of the
issuer, including specific events which may affect the issuer’s
operations or future earnings. Examples include changes in technology
or the discontinuance of a segment of the business.

The intent and ability of the holder to retain its
investment in the issuer for a period sufficient to allow for any
anticipated recovery in market value.

Whether a decline in fair value is attributable to
adverse conditions specifically related to the security or specific
conditions in an industry or geographic area.

The investee’s credit rating and whether the security has
been downgraded by a rating agency.

Whether dividends have been reduced or eliminated, or
scheduled interest payments have not been made.

The cash position of the investee.

FSP EITF 99-20-1 provided additional guidance, reminding entities to
consider all available information relevant to the collectibility of
the security, including “information about past events, current
conditions, and reasonable and supportable forecasts,” when developing
estimates of future cash flows.

Reporting entities should evaluate these factors, placing greater
weight on evidence that is objective and verifiable than subjective
assessments. While there are no bright lines in making such
assessments, there are situations where the conclusion that an
impairment is other than temporary is relatively straightforward. For
example, if the issuer of a corporate debt instrument defaults on
scheduled interest or principal payments, there is strong evidence
that the debt is other-than-temporarily impaired. In addition, based
on SAB 59, if the investor does not have the intent or ability to hold
an impaired security for a sufficient period of time to recover the
recorded amount of the investment, an other-thantemporary impairment
must be recognized. Accordingly, even if an unrealized loss is not
severe, or has been of short duration, an impairment charge should be
recorded if the investor does not plan or is unable to hold the
security long enough to realize the recorded amount.

Because equity securities do not have contractual cash flows, they
are evaluated differently than debt securities. The ability to hold an
equity security indefinitely is not, by itself, a sufficient basis for
the holder to conclude that an impairment charge is not necessary.

The federal government’s recent imposition of conservatorship on
Fannie Mae and Freddie Mac provides an example of other-than-temporary
impairment of an equity investment. As part of the takeover, the
federal government received warrants enabling the government to buy up
to 79.9% of the common stock of those entities for $0.00001 per share.
In addition, the dividends on Fannie Mae and Freddie Mac common stock
were eliminated. Both of these conditions (extensive dilution of
shareholder value through issuance of shares below the current market
price and elimination of the dividend) provide objective evidence that
impairment is otherthan- temporary. Accordingly, most entities that
held Fannie Mae or Freddie Mac common stock recognized impairment
charges in financial statements in the periods immediately after the
conservatorship was announced.

In limited circumstances, the SEC has provided guidance related to
specific types of securities. For example, in October 2008 the SEC
provided guidance on perpetual preferred securities (preferred stock
that has “debt-like” characteristics such as regular dividends, call
features, debt-like credit ratings and are priced like other long-term
callable bonds) allowing entities to account for such equities as debt
in certain limited circumstances.

The SEC indicated that an entity may avoid recognizing an
other-than-temporary impairment for these types of securities by
asserting that it has the intent and ability to continue holding the
security for a sufficient period to allow for an anticipated recovery
in market value as long as the decline in fair value is not
attributable to the credit deterioration of the issuer. This guidance
should be applied with the same rigor as the evaluation of all other
debt or equity securities held by a company in order to ensure the
application of substance over form.

PRACTICAL CONSIDERATIONSBecause assessing impairment requires estimating the outcome of
future events, accountants making such decisions may be subject to
second-guessing. A company’s policy regarding recognition of
impairment on investment securities is often considered a critical
accounting estimate and is disclosed as such in the MD&A section
of SEC filings.

Given the judgment required in this area, auditors and the SEC focus
on management’s reasoning for their impairment decisions when
reviewing companies’ filings. Because of its importance, the SEC staff
has frequently addressed this issue in communications with the industry.

For example, in the Nov. 30, 2006, guidance, the SEC staff states
that, “the Commission expects registrants to employ a systematic
methodology that includes documentation of the factors considered.”
Accordingly, companies should have a formal approach requiring that
all available information be considered when assessing impairment. The
approach should place greater weight on objective evidence as opposed
to subjective factors. Entities must apply that approach consistently
and document the factors considered in reaching their conclusions. For
example, assumptions regarding macroeconomic conditions or
entity-specific factors or events that were considered in assessing
the issuers’ operations and future earnings should be specifically documented.

Identification of the factors to be considered in
completing the analysis.

Documentation of the factors considered and the basis for
the conclusions reached for each security evaluated.

In addition, entities may be able to reduce investor and
counterparty concerns about unrecognized impairment by providing
detailed disclosures about their investments.

At the annual AICPA National Conference on Current SEC and PCAOB
Developments held in December 2008, SEC staff members provided
suggestions about the type of detailed disclosures entities should
consider, including:

Separate identification of other-than-temporary
impairments caused by credit-related issues from those caused by other
factors, such as the absence of an ability or intent to hold a
security to maturity.

The nature of collateral underlying structured
securities, including the types of assets, year of origination, their
credit ratings and credit enhancements.

Information about how illiquidity was considered in
determining the amount of impairment, including the specific
assumptions used, their rationale, and how they evolved as a result of
market conditions.

Such information, if provided with appropriate context, may help
ease the market’s uncertainty regarding management’s estimates.

CONCLUSIONThe accounting rules for evaluating impairment on investment
securities are subjective and require considerable judgment.
Impairment decisions are particularly controversial in times of
economic downturns and market stress, much like the current
environment. While there are no bright lines for making impairment
decisions, there are situations where the need to recognize impairment
is obvious. Absent these situations, judgment is required and entities
making those judgments will be subject to scrutiny from investors,
counterparties and regulatory authorities.

Companies may be able to reduce investor and counterparty concerns
about unrecognized impairment by having formal policies that are
applied consistently, documentation that summarizes the factors
considered and the basis for the conclusions reached, and meaningful
disclosures that enable market participants to assess an entity’s
rationale for concluding that the recorded value of the securities
will ultimately be realized.

Accounting guidance requires entities to categorize
an investment security into one of three categories upon
acquisition: held to maturity (“HTM”), trading, or available for
sale (“AFS”). In addition to defining the three classifications
of securities, an entity is required to assess both the classification
of AFS and HTM securities each reporting period and to determine
whether any declines in fair value below amortized cost should be
considered other than temporary.

There are two primary accounting models for
assessing impairment on securities. EITF 99-20 applies to all
credit-sensitive mortgage- and asset-backed securities and certain
prepayment- sensitive securities and FAS 115 applies to all other
securities, except investments accounted for under the equity-method.
Subsequent to the issuance of FSP EITF 99-20-1, the models are
essentially the same.

Companies must disclose, (in tabular format) the
amount of unrealized losses and the aggregated fair value of
investments with unrealized losses in investment securities whose
fair value is less than book value and for which an
other-than-temporary impairment charge has not been taken.
Additional narrative disclosure is required to provide insight into an
entity’s rationale for concluding that existing impairment(s) is temporary.

Entities should consider all available evidence in
determining whether an other-thantemporary charge should be
recognized. Greater weight should be placed on evidence that is
objective and verifiable than subjective assumptions. The application
of a “bright line” or “rule of thumb” test is not appropriate.

Entities should employ a systematic methodology
that is applied consistently and includes formal documentation of
the factors considered when assessing impairment.

Emerging Issues Task Force Issue No. 99-20,
Recognition of Interest Income and Impairment on Purchased
Beneficial Interests and Beneficial Interests That Continue to Be
Held by a Transferor in Securitized Financial Assets

This free report expands on the most commonly found scams, why education and specialized IT knowledge help to lessen security vulnerabilities, and why every firm should plan carefully for how it would respond to a breach.